Don't Cut The Payroll Tax

Rising unemployment is fueling support, primarily among Republicans, for the idea of temporarily cutting the Social Security tax. While superficially attractive, this is actually a dreadful idea that will not stimulate employment at all and will just make Social Security's finances more precarious.

The simple idea is this. The 15.3% payroll tax creates a wedge between what it costs a business to employ an average worker and the after-tax wage he or she receives. If the tax were cut, then theoretically businesses would be able to pay workers less without reducing their net wage. By reducing their labor costs, businesses will therefore hire more workers.

But what chance is there that workers will permit employers to reap the benefits of a lower payroll tax rate? In my opinion, none. Workers will insist that they get all the benefits in the form of higher take-home pay. Consequently, there will be no reduction in labor costs for employers and no reason why this measure will reduce unemployment.

Moreover, it's clear from looking at labor markets that the problem for employers isn't that labor costs are rising excessively, but rather that there is no demand for their output. Under such conditions, a small cut to labor costs, such as might result from lowering the payroll tax, is very unlikely to do much of anything to expand employment.

Some may argue that simply putting more dollars into workers' pockets is good for the economy because it will stimulate spending. However, this is unlikely to be the case. First, the payroll tax cut would be temporary, and we know from experience that people tend to save temporary increases in their income. That's why last year's $300 tax rebate did nothing to stimulate growth.

Second, the payroll tax cut would only put money in the pockets of those who already have jobs. But the people most in need of help and most likely to spend a temporary increase in their income are the unemployed. They will get nothing from this proposal.

Third, much of the payroll tax cut will accrue to those with high incomes since there isn't any practical way of limiting the payroll cut just to those with low incomes. According to data from the Tax Policy Center, the wealthiest 40% of households now pay just over two-thirds of all Social Security taxes; consequently, they would reap two-thirds of the benefits of a cut in the Social Security tax rate. And the wealthy would be even more likely to save any increase in take-home pay. Ordinarily, that would be good, but what the economy really needs right now is spending. Increased saving under current economic conditions is, unfortunately, a drag on growth.

But the biggest problem with cutting the payroll tax is that it isn't really a tax at all. A tax, by definition, is a compulsory payment for which no specific benefit is received in return. This is not true of Social Security. The vast bulk of workers get back all the money they put into Social Security in the form of a cash benefit in retirement and most get a substantial return. (See this Congressional Budget Office study.) That's why Franklin D. Roosevelt always insisted that the money withheld from workers' paychecks for Social Security was not a tax but a "contribution."

That is not just a politically convenient semantic difference. To a large degree, Social Security is a forced saving program in which there is a real and tangible connection between what one puts in and what one gets out. As economist Richard Disney explained in a recent paper:

"To the extent that pension contributions are perceived as giving individuals rights to future pensions, the behavioral reaction of program participants to contributions will differ from their reactions to other taxes. In fact, they might regard pension contributions as providing an opportunity for retirement saving, in which case contributions should not be deducted from household's earnings, and should not be included in the tax wedge."

In other words, the Social Security tax is more akin to a deduction from one's paycheck for a 401(k) contribution. Although the worker loses the ability to spend the money immediately, the income is not lost because he knows he will get it all back plus interest when he retires. That is why 401(k) contributions are considered part of one's compensation rather than a reduction of it.

For this reason, economists increasingly question whether the Social Security tax reduces employment at all. In a World Bank paper, economists Peter Orszag, now director of the Office of Management and Budget, and Joseph Stiglitz, winner of the Nobel Prize in economics, said it is wrong to infer that a mandatory savings program such as Social Security "necessarily reduces labor supply."

To the extent that there is a true Social Security tax, it is only to the extent that the present value of contributions exceed the present value of benefits. When benefits exceed contributions, which they do for all low-income workers and most of those in the middle class, the Social Security system actually reinforces work incentives--the more you pay into Social Security, the more you get back in retirement.

Historically, this effect was quite powerful because the early generation of those paying Social Security taxes got back vastly more than they paid in, giving them a net negative tax rate. But as payroll tax rates have risen, the rate of return has fallen. This is one of the key reasons why adding private accounts to Social Security would be a good idea.

This is not the end of problems with a temporary cut in the Social Security tax. Another one is that it will involve a considerable of loss in revenue to the Social Security Trust Fund. As it is, tax revenues are just barely sufficient to pay current benefits.

If the Treasury Department makes up the loss by injecting general revenues into the trust fund, then the deficit will rise and we will be on a slippery slope toward general revenue financing for Social Security. When that happens, the essential linkage between taxes paid and benefits received breaks down and what is now perceived by workers as a contribution will become a tax. General revenue financing will also make Social Security into more of a welfare program than an earned pension. History shows that the former can be cut and even abolished, while the latter is virtually invulnerable, politically.

Another problem is the dubious temporary nature of the proposed Social Security tax cut. As we have seen too often in recent years, temporary tax cuts often become quasi-permanent. The tax credit for research and development was scheduled to expire decades ago but always gets extended at the last minute. Barack Obama has proposed extending many of George W. Bush's tax cuts, and there is powerful support in Congress for extending the tax credit for first-time home buyers that expires at the end of next month.

If the temporary Social Security tax cut also becomes quasi-permanent, then so will the general revenue financing necessary to keep paying Social Security benefits, thus pushing the system further down the slippery slope toward becoming a pure welfare program.

I strongly suspect that the main reason why a cut in the Social Security tax is so popular among Republicans is because it's the only way they can cut taxes for almost half of the country. According to another report from the Tax Policy Center, 46.9% of tax filers will pay no federal income taxes this year, up from 37.3% in 2006. History shows that once a group has been exempted from taxation it is very hard to put them back on the tax rolls except during world wars.

Ironically, the main reason why so many people have no income tax liability is because of the Earned Income Tax Credit, which was instituted by Republicans in the 1970s for the express purpose of offsetting the payroll tax liability of those with low incomes. Because the EITC is refundable, the bottom 40% of tax filers actually have a negative income tax liability--they receive money from the Treasury rather than paying money to it. For those in the bottom 20% of tax filers, the EITC offsets more than 100% of their payroll tax liability.

Finally, I think conservatives make a terrible mistake by undermining the payroll tax. It's really the best tax the federal government has--it's broad-based, has a single low rate, exempts income from capital and doesn't apply to wages above $106,800 (except for the 1.45% Medicare tax). It's just about the perfect tax from a conservative point of view. In my opinion, cutting the payroll tax to deal with a temporary unemployment problem risks having it replaced down the road with something far worse, economically.